Market Balances Reflected in Changing Futures Price Spreads

As supply and demand balances loosened in the second half of 2014, global inventories increased and crude oil prices for near-term delivery declined substan­tially more than prices for delivery farther into the future, reports the Energy Information Administration (EIA). In January 2015, the price discount of near-term deliveries to longer-dated deliveries grew to the highest levels since 2009 for North Sea Brent futures and since 2011 for West Texas Intermediate (WTI) futures.

As of Jan. 27, the difference between the front-month contract and the six-month contract was $7.33/bbl lower for Brent and $8.67/bbl lower for WTI than at the start of July, before the steep declines in oil prices. The futures curves moved from backwardation (when prices for near-term deliveries are higher than prices for longer-dated deliveries) in early July to contango (when prices for near-term deliveries are lower than prices for longer-dated deliveries) over this period.

The higher price for longer-dated contracts in a contango market provides an incentive to store crude oil for future delivery. As low-cost storage capacity fills, more expensive storage options are needed, such as floating stor­age—keeping crude in tankers outside of coastal refining centers. Increases in the cost of storage put downward pres­sure on near-term prices. At the same time, growing inven­tories and a looser market balance reduce the price effect of potential future supply disruptions, lowering risk premi­ums in crude oil markets. In late 2013 and early 2014, crude oil futures curves were backwardated as markets faced persistent unplanned supply outages. Uncertainty in future supply meant that market participants were willing to pay a premium to hold physical crude oil, pushing up near-term prices. The currently steep contango signifies the opposite—that markets are amply supplied.

Petroleum inventory data for countries in the Organization for Economic Cooperation and Develop­ment (OECD) show the relationship between rising inven­tories and steepening contango. OECD inventory figures for August 2014, the latest available, show commercial petroleum inventories rose by 34 MMbbl year over year. The average first- to sixth-month spread for Brent prices in August was minus $174/bbl, a year-over-year decline of $5.91/bbl in the spread. As noted, first- to sixth-month spreads have continued their steep decline over the past six months. The latest forecasts show OECD inventories ending January 2015 161 MMbbl over last year, similar to the build experienced during the first quarter of 2009 when inventory builds reflected lower demand driven by a major decline in global economic activity.

A similar relationship holds for futures price spreads and changes in U.S. inventories, including stocks in Cushing, Okla., where the WTI futures contract is delivered. The year-over-year changes in WTI first to sixth month spreads are not as steep as those in the Brent market, but still reached the sharpest drop for WTI since 2009. Using EIA data, total U.S. commercial crude oil inventories stood at 407 MMbbl as of January 23, 61 MMbbl higher than the 2010-2014 average and 49 MMbbl higher than at the same time a year earlier. Recent inventory changes reflect builds in Cushing averaging 1.5 MMbbl a week since November. Cushing storage as of Jan. 23 was more than double the end-of-July level. Future movement toward a flatter price spread—first- to sixth-month spread increasing closer to zero dollars a barrel—would indicate that market balances are beginning to narrow. EIA forecasts that market balances will tighten in the last quarter of this year.